Why the 4% Rule Doesn’t Work for Early Retirement (FIRE)

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The 4% rule is a common rule of thumb in many retirement planning circles, including the Financial Independence, Retire Early (FIRE) community in particular.

What does the 4% rule actually mean?

Should the 4% rule be used for any FIRE-seeker?

Does the 4% rule really matter to retirement planning at all?

Read on to find out our take, including what rules of thumb (if any) we’re using at Cashflows & Portfolios for our early retirement dreams.

The 4% rule is really a starting point for a safe withdrawal rate

Unlike 2 + 2 = 4, the 4% rule is not really a universal truth for any retirement plan at all.

It is, however, in our opinion, a great starting point to understand the impacts of asset decumulation, related to inflation, over time.

As you’ll read more about in the sections below, the 4% rule is fraught with many problems. None more so than for an early retiree or FIRE-seeker. In some cases, for the FIRE community, we believe the 4% rule should no longer be used at all.

Are any financial rules really rules?

Backing up, here is the source for the 4% rule.

The article from 1994!

4% rule

Despite the geeky photo, by all accounts, Bill Bengen was one heckuva guy and a smart guy as well!

Potentially no other retirement planning rule of thumb has received more attention over the last 25-30 years than Bengen’s publication about the 4% rule. This publication in 1994 has triggered a new generation of devotees and arm-chair financial planners that are using this quick-math as a way to cement some retirement dreams. We believe that is a mistake for a few reasons.

First, let’s unpack what the 4% rule really means.

What does the 4% rule actually mean?

From the study:

“In Figures 1 (a)-l(d), a series of graphs illustrates the historical performance of portfolios consisting of 50-percent intermediate-term Treasury notes and 50-percent common stocks (an arbitrary asset allocation chosen for purposes of illustration). I have quantified portfolio performance in terms of “portfolio longevity”: how long the portfolio will last before all its investments have been exhausted by
withdrawals. This is an intuitive approach that is easy to explain to my clients, whose primary goal is making it through retirement without exhausting their funds, and whose secondary goal is accumulating wealth for their heirs.”

Unpacking this further, for those that do not want to read the entire study, here is something more succinct from Bengen:

Bengen 4% rule from 1994

“Should be safe”.

Again, the theory is one thing. Reality is something different and the financial future is always subject to change. Furthermore, if you’re blindly following this formula without considering whether it’s right for your situation, let alone putting in some guardrail approach to monitor your portfolio value at various checkpoints, you could end up either running out of money prematurely or being left with a huge financial surplus that you could have spent during your retirement. We’ll prove that point in a bit from another leading author.

Should the 4% rule be used for any FIRE-seeker?

Probably not. For many reasons.

Recently, Vanguard published an outstanding article about the need to revise any thinking about the 4% rule for the FIRE movement – a driver for this post.

Although the 4% rule remains a decent rule of thumb we believe most FIRE-seekers should heed the cautions in the Vanguard post. Here are some of our thoughts based on the article’s contents.

  • Caution #1 – FIRE-seekers should not rely on past performance for future returns

We agree. In looking at this Vanguard set of assumptions below, and based on our own personal investing experiences, we believe historical returns should not be used to guarantee any future results.

Vanguard - 4% rule

Source: Vanguard article – Fueling the FIRE movement

While the FP Canada Standards Council doesn’t have a multi-year (10-year) return model in mind, they did highlight in their latest projection assumption guidelines that going forward, investor returns may not be as juicy as in years past.

FP Canada 2021 Projections

Source: FP Canada Standards Council.

This means for any historical studies, while interesting, may not be a great predictor of any future outcomes.

  • Caution #2 – The FIRE-seeking time horizon is longer

Bengen noted in his 1994 study:

“Therefore, I counsel my clients to withdraw at no more than a four-percent rate during the early years of retirement, especially if they retire early (age 60 or younger). Assuming they have normal life expectancies, they should live at least 25-30 years. If they wish to leave some wealth to their heirs, their expected “portfolio lives” should be some longer than that. “

Bengen goes on to say:

“If the client expects to live another 30 years, I point out that the chart shows 31 scenario years when he would outlive his assets, and only 20 which would have been adequate for his purposes (as we shall see later, a different asset allocation would improve this, but it would still be uncomfortable, in my opinion).
This means he has less than a 40-percent chance to successfully negotiate retirement–not very good odds.”

To paraphrase, Bengen’s study was relevant to 30 years in retirement. Not 35 years. Not 40 years and certainly not 50 years like some FIRE-seekers may need if they plan to retire at age 40 and live to age 90 (or beyond).

This is simply a huge reminder that your time horizon is a critical factor when it comes to retirement planning.

  • Caution #3 – FIRE-seekers may need to live with more stocks

Bengen’s 1994 study was based on the following:

“Note that my conclusions above were based on the assumption that the client continually rebalanced a portfolio of 50-percent common stocks and 50-percent intermediate-term Treasuries.”

What might happen if the Bengen portfolio was adjusted to 75% stocks and 25% fixed income?

“Would a higher percentages of stocks, given their higher rates of return, be beneficial to the client?”

Yes.

Bengen 75-25 1994 study

From the study:

“Clearly, the heavier weighting in stocks in Figure 3(a) has produced some fairly significant improvements. Fully 47 scenario years result in portfolio longevities of the maximum of 50 years,
while only 40 scenario years attained that pinnacle in the earlier chart. The only penalties occur in portfolio year 1966, which is shortened by one year, from 33 to 32 years, and in 1969, which is shortened from 36 years to 34. All the other scenario years have equal or greater longevity.”

The takeaway message is (historically speaking) to achieve a higher rate of return and to support portfolio longevity, one must consider a higher, longer-term weighting in stocks over fixed income.

The Bengen study was based on a 50-50 stock to fixed income allocation. We believe FIRE-seekers should at least consider a 75% weighting in their portfolio to stocks: to fight inflation and to mitigate portfolio longevity risks.

  • Caution #4 – FIRE-seekers must consider dynamic spending

The reality is, your spending today in your asset accumulation years is dynamic – spending is not a straight line. Therefore, we wouldn’t expect such spending to fall into any straight-line thinking either.

From the Vanguard article:

The 4% rule uses a dollar-plus-inflation strategy. In your first year of retirement, you spend 4% of your savings. After your first year, you increase that amount annually by inflation. This approach allows you to calculate a stable, inflation-adjusted amount to withdraw each year.”

“However, this approach doesn’t take market performance into account.”

Unfortunately with any 4% rule guidelines – it does not account for real-life market fluctuations and your spending patterns to match. Thinking about a dynamic or Variable Percentage Withdrawal (VPW) strategy in our opinion is much more useful and practical.

Variable Percentage Withdrawals (VPW) 101

The essence of this approach is to compute an income payment required to deplete your portfolio at N years assuming asset allocation and portfolio returns during retirement.  For example, N years could be age 99 or 100.  This method uses variable (and an increasing) percentage (hence the name) to determine withdrawals from a portfolio during retirement.

Each year, the withdrawal is determined by multiplying that year’s percentage by the current portfolio balance at the time of withdrawal.  Consider VPW as return-adjusted withdrawals working in a defined timeline.

Consider this VPW table from Bogleheads:

Variable-Percentage Withdrawal Rates Based on Age and Asset Allocation
Age20% Stocks
80% Bonds
30% Stocks
70% Bonds
40% Stocks
60% Bonds
50% Stocks
50% Bonds
60% Stocks
40% Bonds
70% Stocks
30% Bonds
80% Stocks
20% Bonds
403.2%3.4%3.6%3.9%4.1%4.4%4.7%
413.2%3.4%3.7%3.9%4.2%4.4%4.7%
423.2%3.4%3.7%3.9%4.2%4.4%4.7%
433.2%3.5%3.7%3.9%4.2%4.5%4.7%
443.3%3.5%3.7%4.0%4.2%4.5%4.7%
453.3%3.5%3.7%4.0%4.2%4.5%4.8%
463.3%3.5%3.8%4.0%4.3%4.5%4.8%
473.3%3.6%3.8%4.0%4.3%4.5%4.8%
483.4%3.6%3.8%4.1%4.3%4.6%4.8%
493.4%3.6%3.9%4.1%4.3%4.6%4.8%
503.4%3.7%3.9%4.1%4.4%4.6%4.9%
513.5%3.7%3.9%4.2%4.4%4.6%4.9%
523.5%3.7%4.0%4.2%4.4%4.7%4.9%
533.5%3.8%4.0%4.2%4.5%4.7%5.0%
543.6%3.8%4.0%4.3%4.5%4.7%5.0%
553.6%3.9%4.1%4.3%4.5%4.8%5.0%
563.7%3.9%4.1%4.3%4.6%4.8%5.1%
573.7%3.9%4.2%4.4%4.6%4.9%5.1%
583.8%4.0%4.2%4.4%4.7%4.9%5.1%
593.8%4.0%4.3%4.5%4.7%4.9%5.2%
603.9%4.1%4.3%4.5%4.8%5.0%5.2%
613.9%4.2%4.4%4.6%4.8%5.0%5.3%
624.0%4.2%4.4%4.6%4.9%5.1%5.3%
634.1%4.3%4.5%4.7%4.9%5.2%5.4%
644.1%4.3%4.6%4.8%5.0%5.2%5.4%
654.2%4.4%4.6%4.8%5.1%5.3%5.5%
664.3%4.5%4.7%4.9%5.1%5.4%5.6%
674.4%4.6%4.8%5.0%5.2%5.4%5.6%
684.5%4.7%4.9%5.1%5.3%5.5%5.7%
694.6%4.8%5.0%5.2%5.4%5.6%5.8%
704.7%4.9%5.1%5.3%5.5%5.7%5.9%
714.8%5.0%5.2%5.4%5.6%5.8%6.0%
724.9%5.1%5.3%5.5%5.7%5.9%6.1%
735.0%5.2%5.4%5.6%5.8%6.0%6.2%
745.1%5.3%5.5%5.7%5.9%6.1%6.3%
755.3%5.5%5.7%5.9%6.1%6.3%6.5%
765.5%5.6%5.8%6.0%6.2%6.4%6.6%
775.6%5.8%6.0%6.2%6.4%6.6%6.8%
785.8%6.0%6.2%6.4%6.6%6.8%7.0%
796.0%6.2%6.4%6.6%6.8%7.0%7.2%
806.3%6.4%6.6%6.8%7.0%7.2%7.4%
816.5%6.7%6.9%7.1%7.2%7.4%7.6%
826.8%7.0%7.2%7.3%7.5%7.7%7.9%
837.1%7.3%7.5%7.6%7.8%8.0%8.2%
847.5%7.6%7.8%8.0%8.2%8.4%8.5%
857.9%8.0%8.2%8.4%8.6%8.8%8.9%
868.3%8.5%8.7%8.9%9.0%9.2%9.4%
878.9%9.0%9.2%9.4%9.6%9.7%9.9%
889.5%9.7%9.8%10.0%10.2%10.3%10.5%
8910.3%10.4%10.6%10.7%10.9%11.1%11.2%
9011.1%11.3%11.5%11.6%11.8%11.9%12.1%
9112.2%12.4%12.5%12.7%12.9%13.0%13.2%
9213.6%13.8%13.9%14.1%14.2%14.4%14.5%
9315.4%15.5%15.7%15.8%16.0%16.1%16.3%
9417.7%17.9%18.0%18.1%18.3%18.4%18.6%
9521.0%21.1%21.3%21.4%21.5%21.7%21.8%
9625.9%26.1%26.2%26.3%26.4%26.6%26.7%
9734.2%34.3%34.4%34.5%34.6%34.7%34.8%
9850.6%50.7%50.8%50.9%50.9%51.0%51.1%
99100.0%100.0%100.0%100.0%100.0%100.0%100.0%

You can find more information about VPW on My Own Advisor’s site here.

While Vanguard is correct that every spending/drawdown strategy has pros and cons, a VPW strategy may be more optimal than most since it essentially allows you to spend more in “good years” and requires some curtailing of spending in “bad years” – therefore allowing you to better define a range for your income stream – a ceiling and floor per se.
From Vanguard:
“Giving yourself more spending flexibility may decrease your income stability, but it increases your long-term chance of success. Our research shows that when a FIRE investor with a 50-year retirement horizon uses a dynamic spending strategy, their probability of success in retirement increases from 56% to 90%.**”
That’s a quantum leap in retirement planning success.

Does the 4% rule really matter to retirement planning at all?

Yes, it does, but the application should be limited in our opinion. In fact, work with clients of late and our own financial projections and simulations tell an important tale.
Using a fictional value of $100,000 inside a TFSA, for a 40-year-old today, we were curious to find out how long that balance would last, applying the 4% rule, adjusted to inflation of 2% over time. The results including leveraging some real, historical returns, were interesting.
Here are the assumptions:
  • Portfolio: 80% equities/ 20% fixed income
  • Annual Return: 5.70%
  • Retirement age: 40
  • TFSA Balance: $100,000
  • Inflation rate: 2%
  • Withdrawal rate: 4% increasing with inflation

The result?  Using our retirement projection tools (contact us if you need some help determining if you have enough to retire), assuming a consistent return of 5.7%/year, the TFSA ran dry by age 98.  Not bad, using the Bengen 4% withdrawal rule (increasing to inflation), the money lasted a full lifetime (for most).

While achieving consistent returns year after year would be nice, the market does not work that way.  Some years will be up, others down which is fine while an investor is accumulating, but in retirement, the sequence of returns really matters.  How much?  Well, let’s run the same projection using the worst real-world 10-year sequence of returns since 1965.

The result? The same TFSA is depleted by age 65, only 25 years after starting retirement.

This illustrates the damage that can happen to a portfolio when withdrawing a constant amount year after year and not adjusting for down years (see VPW above for a safer strategy).

Final Thoughts

Altogether, if you expect to live for 30 years or less from the date of retirement, then the 4% rule may work for you providing that you have the right allocation of stocks/bonds (at least 60% equities).  However, if you are an early retiree in your 40’s or 50’s, and you have a long retirement to pay for, then you may want to consider a safer strategy like the VPW schedule indicated above.  As Vanguard modelled with over 10,000 scenarios, the VPW strategy has a high success rate with longer retirement time frames which is especially important during turbulent times.

 

 

 

 

 

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6 thoughts on “Why the 4% Rule Doesn’t Work for Early Retirement (FIRE)”

  1. Excellent post. I am trying to learn more about VPW and I came across an article by Michael James where he argues that the rate of return used in the original VPW by Bogleheads is too high. They used a rate of return of 5% for equities and 1.9% for fixed income. Michael is suggesting that we need to include inflation and he is suggesting to use 4% for equities and 0 for fixed income means a lower withdrawal amount. I am a little confused now as to what growth rate to use for my own situation. What would you recommend? Thank you

    Reply
    • Thanks Kevin.

      Knowing Michael a bit, I suspect he is being more conservative with his estimates. Of course, we won’t know if he or Bogleheads are correct until time passes. The results could be somewhere in between. When in doubt, probably wise to err on the conservative side for any long-term equity or fixed-income returns – so Michael’s lower estimates might work best. Meaning, lower estimates of returns and higher inflation estimates are better. This way, your major problem in retirement is either a “too large of a nest egg” problem or “a higher tax problem”. Those are likely better problems to have than running out of money.

      What do you think for returns long-term, as in 20-year+ ??

      In terms of real-returns, after inflation is factored in, I don’t see fixed income doing well. So, zero could be correct.
      I’m a bit more bullish on equities so likely 4-5% real-returns should be doable.
      CAP

      Reply
  2. Thanks CAP

    I do agree with you that it is better to cautious but at times it is difficult to know how cautious you need to be. You read many articles that suggest a withdrawal rate of 3-3.5% given the prolonged equity bull market we had.

    In the example above assuming retirement age of 55 and 80/20 Equity/Fixed income % to generate an income of $50,000 per year: using 5% equity growth you will need a nest egg of 1,080,000 and at 4% you will need 1,220,000 which is an extra 140K. That could mean working 2 or more years at least.

    Reply
    • The 4% rule is a nice starting point but hardly a rule for many – especially anyone that wants to retire sooner than most let alone have a 40+ year retirement / semi-retirement timeframe!!
      CAP

      Reply

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